2015 Quarterly Summaries

Review of Securities Markets, Third Quarter, 2015

Equity markets around the globe dropped during the quarter as fears of slowing global economic growth increased. Many had suspected that China’s economy, the world’s second largest, was beginning to slow down, and economic data released during the quarter confirmed those suspicions. In late August, a measure of Chinese manufacturing activity, the PMI Manufacturing Index, hit a six- year low. The same report also showed a marked decrease in new orders and Chinese exports. The slowdown in China led to downgrades to growth estimates of other emerging economies that rely on Chinese demand for their exports and also contributed to a further decline in commodities prices. Lower commodity prices, in turn, added to concerns that third quarter U.S. corporate earnings could be dragged down by weak earnings from energy companies.

The U.S. stock market (as measured by the S&P 500) dropped more than 6% during the third quarter as a stronger dollar and lower energy prices continued to be a headwind for corporate earnings. Small cap stocks, as measured by the Russell 2000 Index, underperformed large cap stocks during the quarter and year-to-date. Small cap stocks tend to underperform when fears are elevated as investors look to reduce risk in their portfolios.

Foreign stocks underperformed U.S. stocks in the third quarter and now trail U.S. stocks year-to- date after having outperformed earlier in the year. Emerging market stocks were the weakest performers. The economies of many emerging nations are highly levered to the production and export of natural resources so any decline in commodity prices directly impacts the economic growth of the country. In addition, many of the largest emerging countries in Asia rely heavily on exports to China which are expected to decline as the Chinese economy slows.

The U.S. bond market rallied during the quarter as investors purchased safe haven assets and the U.S. Federal Reserve postponed a highly-anticipated increase in the Fed Funds rate. Going into the quarter, most investors expected the Fed to begin raising interest rates at their September meeting. As fears of a global economic slowdown increased, it became less clear whether the Fed would make the move. The day before the announcement, the yield on the U.S. 10-year Treasury note was 2.30%. Once the announcement was made that a rate rise was on hold, yields began dropping with the 10-year note closing at 2.04% at the end of the quarter. Decreasing yields led to gains in U.S. bonds with the Barclays Aggregate Bond Index up 1.23% for the quarter.

Commodities dropped sharply on demand concerns and elevated production levels in the energy sector.

The Big Picture

With all of the poor financial headlines over the past quarter, it can sometimes be difficult for investors to maintain their perspective. When markets are falling and fears escalate, it is easy to fall victim to the desire to do something to protect yourself from the declines. Research in the area of behavioral finance has shown that the pain of financial loss is much greater than the joy of a financial windfall. Making an emotional decision to avoid the pain is one of the biggest mistakes an investor can make. With that in mind, let’s take a step back and try to cut through the headlines and look at the bigger picture.

The recent economic data out of China has been less than stellar, but shouldn’t be a big surprise. The reality is that China’s GDP growth has been declining since it hit a peak of approximately 14% in 2007. Some of the reasons for this decline have been the intentional shift of Chinese authorities to try to move from an industrial, infrastructure driven economy to a more consumer-oriented, service economy. To the extent the Chinese are successful in making this transition, their economy would likely be more stable over the long term. It is also important to realize that the current data out of China suggests a slight slowdown in economic growth (to just below 7%), but no one expects an outright recession any time soon.

While China is slowing, the U.S. economy has continued to expand at a modest pace during the first half of the year. The most recent report (second quarter) showed gains in virtually all major categories including consumer spending, business investment and net exports. U.S. consumer confidence has also been unusually strong, even in the face of stock market declines. This latest report also showed a significant increase in planned purchases of homes and cars, which suggests a potential increase in future consumer spending in the U.S.

The Eurozone continues to struggle, but ultimately their struggles could lead to higher stock prices in the region. Eurozone growth has remained tepid with the latest report showing GDP growth of 1.5%. Deflation remains a concern as the latest report showed core inflation was unchanged at 0.9%. Low growth and deflation concerns in the Eurozone have led many to believe that an expansion of the European Central Bank’s quantitative easing program is likely. The consensus is that a sizable increase in the program may occur before the end of the year. Announcements or expansions of QE programs in the U.S. and Europe have generally led to an increase in stock prices in those regions.

Make no mistake. It is not our intent to say that the bigger picture is all sunshine and roses. In fact, our analysis of market behavior suggests that downside risks in the stock market are currently higher-than-normal. Moreover, we are in an environment where global economic growth is low which usually equates to below average expected returns of stocks and bonds. The good news is that lower-than-average growth rates should not persist forever. Investors who are patient and who can maintain a long-term focus will likely be rewarded. And in the end, that is really the biggest and brightest picture of all.

Key Economic Indicators

The latest U.S. GDP (Gross Domestic Product) figures showed an increase in real GDP growth for the second quarter of 2015 at an annual rate of 3.9%. Gains were shown in all major segments of GDP with particular strength in consumer spending and net exports. Strong growth in the second quarter followed a very weak first quarter when GDP grew just 0.6%. Taking the first and second quarters together, growth increased at a modest 2.2% annual rate.

The U.S. Federal Reserve continued to hold the target range for the federal funds rate at 0% to 0.25%. Many expected a rate increase at the September meeting, however, the Fed cited low inflation as a reason to remain accommodative. The Fed also mentioned that they were “monitoring developments abroad,” which suggests some attention is being paid to developments in China and other emerging markets.

The U.S. unemployment rate dropped to 5.1% in August, however, the September report showed some unexpected weakness. Non-farm payroll growth in September came in at 142,000 but was well below expectations. Non-farm payrolls for July and August were also revised downward by a total of 59,000 jobs.

U.S. inflation has remained low. The latest Consumer Price Index data (August) showed an annual inflation rate of 0.2%. The low inflation rate continues to be driven by decreasing energy costs over the last 12 months. Core CPI (CPI less food and energy) posted an annual increase of 1.8% through August.

Commodity prices dropped during the third quarter due to concerns about global demand. The Bloomberg Commodity Index was down 14.47%. The price of crude oil dropped 24% to $45 per barrel, as concerns about energy demand from China increased. Gold (-4.9%, $1,115) and silver (- 7.5%, $14.49) both moved lower during the quarter.

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